To call the finance industry a “mixed bag” would be a gross understatement. There are a few functions essential to industrial capitalism that banks, bill brokers, and financiers mastered centuries ago, like moving funds from savers to borrowers, a process described marvelously by Walter Bagehot in 1873. Then there’s the constant stream of financial “innovations,” as bankers churn out new and exciting products to separate people from their money — and that’s when they’re not simply robbing their customers.
The problem with financial innovation is that there are only a few fundamental functions a financial company can perform. For example, an insurance company can spread the risk of an early death across a population by selling insurance to every member of population, moving money from those who survive to the survivors of those who live. A bank can make you a loan today that will be paid back with your future income, in effect “accelerating” your salary by moving it forward in time. A bank can borrow money from you today, promising to pay it back over time, while giving the money in a lump sum to a borrower.
What the finance industry can’t do is create value. You may be grateful to a stock broker for facilitating a profitable trade, but any trade that’s profitable for you is unprofitable for the guy on the other side of it. You may be glad to loan your money to the bank for interest, but the guy borrowing the money would surely rather not pay interest on his loan. The finance industry simply rests in the middle, taking a cut of every transaction.
Indexed annuities make no sense
I have to assume these products will be banned eventually since they are marketed and sold in extremely abusive fashion, but for now, here’s how they work. A fixed annuity is combined with an index (for example the S&P 500), so that the value of the annuity contract is adjusted according to the performance of the index.
Usually the value of the contract is adjusted upwards annually or biannually according to the change in the value of the index since the last adjustment date, up to a maximum adjustment amount, typically between 3% and 6%. If the index rises by more than that, you get the maximum adjustment but no more. If the index declines between adjustment dates, the value of the contract isn’t adjusted downward.
There are three big problems with this product:
- Maximum adjustment. If the insurance company buys options against the relevant index in order to hedge against changes in the contract’s value, and the index rises by more than the maximum adjustment amount, the insurance company gets to keep any profit it shows on the options’ value.
- Dividends excluded. If you were to own the relevant index itself, instead of an annuity indexed against it, you would also earn any dividends paid by the stocks in the index. Reinvested dividends and bond coupons represent a significant part of any investment’s return, and you give them up when you buy a price-indexed annuity.
- High fees. In exchange for giving up “excess” price appreciation and the dividends paid by the underlying index, you also get to pay your insurance agent a commission several times higher than the one on an immediate fixed annuity. The same premium mechanically has to buy a smaller annuity if more of it is going to pay commissions (remember, finance doesn’t create value).
Michael Kitces has a good post focused on the idea of principle protection and equity participation, which is, in principle, the “problem” variable indexed annuities were designed to address. But of course the purpose of annuities is not principle protection and equity participation — it’s to provide a stream of lifetime income!
Single premium immediate annuities make a lot of sense
Today it’s very fashionable to talk about “sequence of return” risk: a retiree might expect their investments to return 6% per year on average over the next 30 years, but if the first 15 years return -6% and the second 15 years return 18%, the 30-year average doesn’t do them any good since they won’t have any assets left by the time the 15-year bull market comes along.
It’s not a terribly popular view, but I think annuities are a perfectly reasonable way to foist sequence of return risk onto somebody else.
Most US retirees’ income will consist entirely of their Social Security old age benefit, which is why their first priority should be maximizing that benefit by delaying their old age benefit as long as possible, even if it means spending down their retirement savings before filing.
But for retirees with expenses in excess of their Social Security benefit, buying a single premium immediate annuity is a sensible way to achieve a guaranteed income that meets those needs.
Just buy the annuity you need
There’s a simple rule of thumb in annuity pricing: the more you want your annuity to resemble an investment, the smaller the annuity will be, or the more you’ll have to pay for it. But investing is cheap and easy! Don’t pay insurance agents and insurance company shareholders a premium to do something you can do yourself for next to nothing.
Figuring out your lifetime retirement expenses isn’t “easy,” but it’s possible. You can even pay a real, professional, fiduciary financial adviser to help you out while calculating those expenses, instead of an insurance salesperson who’s paid more depending on the amount they can convince you that you need.
Once you have a sense of your annual expenses in retirement, you can deduct your Social Security old age benefit and buy an annuity that makes up the difference. It doesn’t matter to me what you do with the difference: you can leave it to your heirs, give it to charity, or buy ornamental bookends. All I want is for you to not pay for “protection” you don’t need given your actual expenses and actual net worth — however much those end up being.